As the inflation event begins to wane, central bankers have been keen to use the narrative to justify why they will keep raising rates, especially when it becomes clear that the driver of inflation is largely supply-side and dampening overall spending (via higher interest rates) Would not be a very effective deployment measure. This is distinct from the debate on the effectiveness of using interest rates to curb spending, which is a separate discussion with no clear conclusions other than probably not. As I’ve pointed out before, it’s hard to argue that inflation was accelerating out of control when it started falling a few months ago. So they had to come up with a different narrative – that while inflation was falling, it wasn’t falling fast enough. That’s the current storyline for officials. This allows them to claim that if it doesn’t come down quickly, then two things are likely to happen: (a) workers will factor higher inflation into their wage needs and trigger a wage-price spiral, even with supply-side factors ( Covid, Ukraine, OPEC) weaken and (b) people will start to expect higher inflation to be the norm and factor it into contractual arrangements and pricing. Neither pattern of behavior shows any signs of becoming entrenched, leaving central bankers with nothing to hide. Even the central bank’s own research shows that no “high inflation” mentality is dominant.
Wage growth is not inflation
On Tuesday (May 30, 2023), the Federal Reserve Bank of San Francisco released its latest “Economic Letter” — To what extent are labor costs driving inflation? – Solve the salary problem.
The study was motivated by the Federal Reserve Chairman’s statement in 2022 that wage changes are driving changes in “nonhousing services” because they are “the largest cost of providing them.”
His thesis has been repeated regularly in a number of different ways by central bankers and senior officials around the world since mid-2021, when mounting inflationary pressures began to emerge.
“Nonhousing services are an important component of headline inflation, accounting for more than half of the core personal consumption expenditures (PCE) price index,” the FRBSF researchers noted.
Additionally, “worker wages and benefits account for the bulk of the company’s costs” to provide these non-housing services.
Previous research has shown that “labor costs have little effect on services sector inflation or overall inflation” because firms can always “absorb such costs into profit margins” and sometimes restructure workplaces to increase productivity, offsetting higher inflation. high wage costs.
The FRBSF paper structures the study by considering the following factors:
…Increases in labor costs act like supply shocks, with businesses passing on higher costs to consumers in the form of higher prices. In contrast, rising labor costs do not appear to be driving inflation through higher demand.
This is an important distinction because it shows that higher wages enjoyed by workers as a result of rising wages do not lead to a situation of excessive demand for goods and services.
Opponents of wage increases in the corporate sector often try to claim that wage increases are inflationary because they put pressure on spending.
The FRBSF paper completely rejects this claim.
Regarding other pathways – higher unit cost/supply effects – research shows:
…the impact is small and happens slowly over a long period of time. A 1 percentage point (pp) increase in labor costs increases the contribution of NHS prices to core PCE inflation by only 0.15 percentage points over four years, or less than 0.04 percentage points per year. This means that the recent rise in the Employment Cost Index (ECI) only contributes about 0.1 percentage point to current core PCE inflation, which is entirely due to the impact on NHS inflation.
In other words, very small second-order type effects, rather than a basis for building the claim that rising interest rates prevent a wage-price spiral.
For further argument, the FRBSF paper produced Figure 2 (reproduced here), which shows the components of the core PCE inflation measure published by the US Bureau of Labor Statistics since 2019.
These components are non-housing services, goods and core goods, and the chart shows that core goods inflation rose “sharply” in 2021, but fell sharply thereafter.
As I pointed out in a blog post last year, the impact is easy to understand in the context of the pandemic and the way governments have responded to the threat.
Not only have supply chains for goods been severely disrupted by illness and factory and transport closures, but governments have also restricted access to services sector activities while providing affected workers with fairly extensive income support.
With income somewhat protected and incapable of engaging in service-related spending, it is clear that diverted spending on goods—home improvement, advance purchases, etc.—will drive up the prices of these goods, especially if they are relatively in short supply case in 2020 and 2021.
Excessive demand inflation is strictly true, but from a policy perspective, this diagnosis has led to destructive policies by central banks and treasuries.
It is clear that overall spending has not increased as much, the problem is a “temporary” drop in supply capacity.
So it is better to go the Japanese route and wait for the supply side to sort things out, while protecting the most vulnerable households from temporary cost-of-living pressures through fiscal injections.
Using macroeconomic policy to stifle spending will only leave higher unemployment and lost income as the supply side overcomes its constrained environment.
The graph shows how this part of the story resolves itself by mid-2022.
Conversely, non-housing services increased their contribution and remained flat through the inflation cycle.
The FRBSF paper calculates:
The NHS contributed 2.4 percentage points to three-month core inflation, 1 percentage point above its average contribution in 2016-19.
Since nominal wage growth has picked up over this period — tracking the CPI — many commentators have blamed the overall PCE trend for the move.
Using quarterly data, the FRBSF study examined the relationship between changes in the Employment Cost Index (ECI), the best measure of labor costs, and NHS inflation between 1988 and 2023.
Therefore, it uses enough data observations to estimate robust econometric models and obtain reliable inferences.
Interestingly (from an econometric point of view), when they split the sample in half around 2020, they found no significant difference in this relationship.
Thus, despite the extraordinary nature of the pandemic, the relationship performance in the current period is similar to the pre-pandemic period.
The first result they reported was:
1. The effect of ECI increases on goods and housing services inflation is negligible and statistically different from zero.
2. The impact on the NHS was positive and statistically significant, but “reasonably small”.
3. “Since ECI growth is about 3 percentage points above pre-pandemic levels, this implies that labor costs are adding about 0.1 percentage points to current core PCE inflation.”
So there’s really not much to see here!
Another question they explore is whether this negligible wage effect works through the supply side (push up costs passed on by firms) or the demand side (higher spending effects), which I mentioned above.
The study concluded:
The ECI has no appreciable effect on the demand-driven component of NHS inflation. Instead, the impact of ECI growth on NHS inflation is entirely supply-driven. Thus, this result suggests that the increase in labor costs acts like a typical supply shock, with firms passing on higher costs to consumers in the form of higher prices.
But as mentioned earlier, this effect is small.
Importantly, they state:
…recent evidence suggests that wage growth tends to follow inflation… [and] … recent labor cost increases may not be a good gauge of the risks to the inflation outlook.
This is a significant study.
I’ve pointed out in the past that it’s hard to prove that wages are driving inflation when you observe real wages falling.
FRBSF research supports this claim – nominal wage growth is catching up to inflation, but not catching up or outpacing it.
This leads us to think that inflation now, because those core commodity supply pressures are fading fast, is driven by profit push – so-called “greed inflation”.
Now, that’s a very plausible explanation for inflationary pressures “on hold” through 2023.
RBA chief still blames wages
Yesterday, the Governor of the Reserve Bank of Australia attended the Federal Senate Budget Committee meeting.
Transcripts are still not available.
But we’ve got a nice set of quotes from his looks.
With productivity growth stagnating, real wages in Australia must continue to fall to bring inflation back to the RBA’s 2% to 3% target range, he claimed.
In other words, he suggested in less words that the RBA will deliberately push the economy into recession in order to achieve further declines in real wages.
For the March 2019 quarter, the real wage index (derived from the ABS wage price index) was 113.1, the most recent peak.
This suggests that real wages have grown by only 13.1% since the September 1997 quarter, when the WPI data series began.
In contrast, GDP per hour of labor input (productivity) increased by 29.6% over the same period, implying a massive redistribution of national income from workers to profits over those 20 years or more
A related indicator is the wage share, which rose from 55% in the September 1997 quarter to 50% in the December 2022 quarter.
Unprecedented profit shifting.
This means that, in simple language, workers’ real wages have grown disproportionately to productivity growth, and that gap has been pocketed by business firms.
In the first quarter of 2023, the real wage index was 107.2 points, while the productivity index increased from 129.6 points to 131.8 points.
As a result, real wages fell by 5.1 percentage points and labor productivity rose by 1.7 percentage points over the period (March 2019 quarter to March 2023 quarter).
Sure enough, productivity growth has been low by historical standards.
But employers still found ways to take advantage of periods of inflation to hold down real wages, while still benefiting from labor productivity through higher profit margins.
So when the RBA governor claims that the only way real wages will rise is through higher productivity, he’s not telling us the whole story.
Even if the Australian economy is currently producing dangerous productivity growth, there is room for non-inflationary real wage growth if we force businesses to stop profit-gouging.
That is, the rate of profit is likely to fall from the inflationary level that would allow the profit share to expand.
in conclusion
However, don’t expect the RBA governor to spell out this message anytime soon.
As I pointed out yesterday, the Governor misled a Senate committee when he claimed that the only profit growth was in the resources sector.
This is obviously not a statement supported by data.
Enough for today!
